So Far, So Good: Government Insurance of Financial Sector Tail Risk

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The US government has intervened to provide extraordinary support 16 times from 1970 to 2020 with the goal of preventing or mitigating (or both) the cost of financial instability to the financial sector and the real economy. This article discusses the motivation for such support, reviewing the instances where support was provided, along with one case where it was expected but not provided. The article then discusses the moral hazard and fiscal risks posed by the government's insurance of the tail risk along with ways to reduce the government's risk exposure.

Key finding:

  • The financial system is crucial to the real economy and at risk of instability. As a result, one reason for the Federal Reserve's discount window and the Federal Deposit Insurance Corporation’s (FDIC) provision of deposit guarantees is to help stabilize banks.
  • Nevertheless, the FDIC, Fed, and Treasury provided extraordinary support on 16 occasions from 1970 to 2020 to prevent or mitigate (or both) financial instability. These interventions have not only supported US banks but also domestic nonbank financial firms, domestic nonfinancial firms, and some foreign participants in the global US dollar market.
  • Private market participants may take this extraordinary support to indicate that similar actions may be taken to in response to future instability incidents, suggesting the government is insuring a large share of the tail risk in the financial sector.
  • Perceived and actual absorption of the tail risk may distort wealth allocation, increase moral hazard, and even pose a risk to the United States' taxpayers.

Center for Financial Innovation and Stability

JEL classification: F33, F36, G18, G21, G23, G28, G32, H12, H6, N22

Key words: financial stability, FDIC, Federal Reserve, Treasury, bailout, financial history

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